ECB As European Lender Of Last Resort = Institutional Purveryor Of A Pan-European Ponzi Scheme

Reggie Middleton's picture

If today's broad market action is confusing you, it shouldn't be.

SPX_8-5-11_flip_flop

What you are experiencing is the effects of global central planning on the financial markets. I just went into this in detail, and regular readers/subscribers have seen this several times this week alone (and for good reason): Do Black Swans Really Matter? Not As Much as ...

I have always been of the contention that the 2008 market crash was cut short by the global machinations of a cadre of central bankers intent on somehow rewriting the rules of economics, investment physics and global finance. They became the buyers of last resort, then consequently the buyers of only resort while at the same time flooding the world with liquidity and guarantees. These central bankers and the countries they allegedly strive to serve took on the debt and nigh worthless assets of the private sector who threw prudence through the window during the “Peak” phase of the circle of economic life, and engaged in rampant speculation. Click to enlarge to print quality…

The result of this “Great Global Macro Experiment” is a market crash that never completed. BoomBustBlog subscribers should reference File Icon The Inevitability of Another Bank Crisis while non-subscribers should see Is Another Banking Crisis Inevitable?

The ECB is now full on taking the Fed's position of buying up junk assets in order to manipulate prices. The Fed is bigger than the ECB and afters years of QE and tens of trillions wasted, we're worse off than when we started. The ECB should have taken notes, alas, they didn't. CNBC reports:

ECB Ready to Buy Italian, Spanish Bonds: Sources -The ECB has agreed in principle  to buy Italian and Spanish bonds if key structural reforms are brought forward, according to people familiar with the matter.

Of course this occurs after Italy figures out it can't sell its own bonds... It Just Got Worse: Italian Treasury Just Announced It Will Not Sell 3 Month Bills At The August 10 Auction:

Of course, it's not just Italy (or Greece, or Portugal, or Ireland) either. From ZH: News Just Keeps Getting Worse: Spain To Cancel August 18 Auction As Bundesbank President Says Opposes ECB Bond Buying

These actions by the ECB are a waste of capital and resources, and when applied to Greece, simply allowed Greek debt to literally freefall afterwards (and haircuts are being passed around anyway). Ditto for Portugal and Ireland, sans government sanctioned haircuts - at least so far (but they're coming, rest assured). Never one to allow good money to fail to be chucked after bad, they do the same with Spain and Italy, apparently failing to notice that it hasn't worked the last three times they tried. Alas, this time is really different. Spain and Italy are truly too big to save in such a fragrant bailout fashion, and if Italy succumbs it will cause the French banking system implode - plain and simple, see France, As Most Susceptble To Contagion,…

This has recently been admitted by Germany, as per Speigel:

Hamburg - Growing up in the federal government, according to SPIEGEL information doubts whether Italy could be rescued by the European EFSF rescue - even if the fund tripled. An economy like Italy was not to support, to being too large, it is said to justify.

The financial needs of the country is huge. According to government experts from the other partner countries may also not lift the guarantee of the entire Italian public debt of over € 1.8 trillion. By then the markets would suspect that Germany was overwhelmed.

Therefore, there is the Federal Government that Italy is through savings and reforms itself from the crisis. The bailout was opposed only designed to catch small to medium-sized countries.

Without the French to help backstop the EU, Germany is all on its own. Reference ZeroHedge on the topic: Explaining How The Just Announced ECB Market Rescue Pledged 133% Of German GDP To Cover All Of Europe's Bad Debt

Two weeks after Zero Hedge readers were informed about it, slowly the sell side is coming to the realization that not only will the EFSF have to be expanded (that much was known), but that Germany, and specifically the outright economy, will be on the hook by an unprecedented amount of money. And expanded it will have to be: not by two, not by three, but by a cool four times, to a unbelievable €3.5 trillion which according to Daiwa's Head of Economic Research, Grant Lewis, is an act which will be necessary to convince financial markets of euro area resolve to save Italy and Spain. Says Lewis: "France, Germany contribution to EFSF’s capital would increase to 80% if Spain, Italy had to drop out of guarantee structure.  France, German contingent liabilities would be > 50% of GDP if EFSF expanded; added to France, Germany current debt may trigger downgrades to both countries." Yes... and no. As we explained when we referred to a far more accurate and complete report by Bernstein, merely a €1.5 trillion expansion in the EFSF, would mean that Germany is on the hook to the tune of €790 billion or 32% of German GDP. If France is downgraded, Germany essentially becomes the sole backstopper of the entire Eurozone, to the tune of €1.4 trillion or 56% of its GDP. Now let's assume Daiwa is correct, and the full amount under the EFSF has to increase to €3.5 trillion. That means that Germany "contin[g]ent liabilities", in the worst case scenario where France again gets downgraded, and it likely will eventually, would surge to about €3.3 trillion, or an insane 133% of German GDP

What is not mentioned by the media is that Germany's banks are coming up on a record CRE mortgage rollover, a rollover on properties which are quite underwater. Expect a(nother) real estate crash shortly.

In addition, for some obscene, arcane reason, someone, somewhere actually believes the ECB can pull off buying everything from everyone at inflated prices without an extremely negative repercussion. I disagree... Vehemently. It is interesting, though, to hear other viewpoints.  BoomBustBlogger Pieter writes...

Reggie:

A Belgian professor (University of Leuven) believes, that the only way to avoid the danger of contagion is to change the ECB into the European lender of last resort. It may print enough money to prevent an institutional bank run.

De Centrale Bank moet de eurocrisis oplossen

De uitweg uit de Europese ellende

standaard.be/.../...
Unfortunately the text in in Dutch.

Pieter has been gracious enough to translate the article for us. As many techies know, a manual translation is just that much more accurate than the Google/Babblefish renditions.

The Central Bank has to solve the euro crisis

The escape from the European misery
Monday August 1 2011  Author: Professor Economics at the KU Leuven.
 
‘Only if the European Central Bank guarantees that the bondholders will be paid, the financial contagion can be  brought to a hold’, PAUL DE GRAUWE has written.

We are getting used to it. The European Counsel is gathering in a crisis atmosphere to put out the fire in the Euro zone. At the end of the meeting the European leaders are making rock hard statements: the crisis is averted, fundamental decisions have been taken, and the euro is saved.

Yep, he's right. We have seen this movie before. Reference the following articles (all well over a year old):

After some days of euphoria the markets turn and the crisis starts all over again. The last European Counsel is no exception to this procedure. Two days the euphoria lasted. We are in full crisis again. The interest rates on Spanish and Italian bonds that had fallen resume their upward tendency. ‘The contagion from Greece had been averted’, the European leaders declared solemnly. Nothing is farther from the truth.
Why is it so difficult to stop the contagion from one country to another? To answer this question you need to understand one of the most essential features of a monetary union. The members of the union issue bonds in a ‘foreign’ monetary unit. With that I mean a unit that they have no control over. Consequently they cannot guarantee the bondholders that they always will have cash available to pay the bonds on maturity. The Belgian government for example cannot guarantee that it will have enough Euros to pay the bond holders. This in contrast to a country that issues its own money. Such a country can guarantee the bondholder that on maturity there will be always cash to pay for the obligations. And there is no limit on the amount of money that the central bank is issuing.
 
Deposits

This situation makes the members of the monetary union very vulnerable for the danger of contagion. It is comparable to the banking sector. If everyone runs at the same time to the bank to change the deposits into cash, the bank has not enough means to accommodate this conversion. Only one bank that has a problem with its solvency suffices for people to have doubts about other banks (the healthy ones as well) so that they will run to their banks too.

It's actually a little more in depth than that, but he definitely gets the point. For those how haven't followed my bank run series...

  1. The Mechanics Behind Setting Up A Potential European Bank Run Trade and European Bank Run Trading Supplement
  2. What Happens When That Juggler Gets Clumsy?
  3. Let's Walk The Path Of A Potential Pan-European Bank Run, Then Construct Trades To Profit From Such
  4. Greece Is Fulfilling Our Predictions Of Default Precisely As Predicted This Time Last Year
  5. The Anatomy Of A European Bank Run: Look At The Banking Situation BEFORE The Run Occurs!
  6. The Fuel Behind Institutional “Runs on the Bank” Burns Through Europe, Lehman-Style!
  7. Multiple Botched and Mismanaged Stress Test Have Created The Makings Of A Pan-European Bank Run
  8. Observations Of French Markets From A Trader's Perspective
  9. On Your Mark, Get Set, (Bank) Run! The D…

This instability of the banking system is solved by charging the central bank to be the ‘lender of last resort’, in other words to take care that the banks have the means to pay the depositors. The existence of this guarantee makes sure that the depositors do not run to the bank and that the guarantee is not (or hardly) executed.

The problem that the members of a monetary union experience is the same as the problem with the banks. It may be solved in a similar way as in the banking sector. It is sufficient that the central bank of the monetary union, the European Central Bank takes the task upon itself of the ‘lender of last resort’. In this way it guarantees that the members of the monetary union always will have the Euros to their disposal to pay the bond holders. It will suffice to take away the fear of investors and the drive of the contagion.
At first the ECB has played this part, though reluctant. Since some months it made clear that it does not want to do this any more. This change of policy of the ECB is the fundamental explanation why the danger of contagion can not be ward off.
The European leaders have tried to offer a reply to this by creating the European Rescue Fund. But this cannot and will not be able to replace the function of the ECB. The main cause is that the rescue fund does not create money and is dependent of the members for its means. And these are limited, in contrast to the means the ECB may dispose of and which are unlimited.

Permanent crisis

Strangely enough, the European leaders have decided during the last summit to allow the acquisitions of bonds directly form the market by the rescue fund, but they failed to place adequate means to its disposal. The rescue fund has no credibility any more and cannot stop the contagion. That is only possible by the ECB, but it has no desire to.
One of the arguments used by the ECB to stop its function as ‘lender of last resort’ is that the guarantee might offer a wrong signal to politicians. By the guarantee they might be tempted to allow too much debt. ‘The ECB will pay for it’. That is indeed risky. But it is a risk as well in the banking sector, in which the ECB offers the same kind of guarantee. The way to solve this problem is not to take away the guarantee because this results in permanent crisis situations, but to create legislation that limits the issuing of government debt
To take away the danger of contagion and to stabilize the financial markets it will be necessary for the ECB to take its responsibility in stead of escaping it. At the same time strong mechanisms have to be implemented to restrain the growth of government debt. All this needs more political unification. It is still a long way to the stabilization of the euro.

Note from Pieter: This translation has no other purpose than to inform Mr. Middleton about the content of an article in the Standaard of August 1 2011. The usual disclaimers apply: it is not my opinion, I offer no warranty as to its completeness, veracity or accuracy. Copyright © 2011

Ths is the problem with the professor's ECB thesis as of right now. It is a near sentient pile of toxic asses. Throughout last year I stated that the ECB's incessant buying of Greek, Irish and Portguese bonds were wiping its equity. Academics disagreed, until....Over A Year After Being Dismissed As Sensationalist For Questioning the ECB's Continued Solvency After Sovereign Debt Buying Binge, Guess What!

 There has been a lot of noise in both the alternative and the mainstream financial press regarding potential risk to the ECB regarding its exposure at roughly 48 to 72 cents on the dollar to sovereign debt purchases through leverage, and at par at that. This concern is quite well founded, if not just over a year or so too late. In January, I penned The ECB Loads Up On Increasingly Devalued Portuguese Bonds, Ensuring That They Will Get Hit Hard When Portugal Defaults. The title is self explanatory, but expound I shall. Before we get to the big boy media's "year too late" take, let's do a deep dive into how thoroughly we at BoomBustBlog foretold and warned of the insolvency of both European private banks and central banks, including the big Kahuna itself, the ECB! The kicker is that this risk was quite apparent well over a year ago. On April 27th, 2010 I penned the piece "How Greece Killed Its Own Banks!". It went a little something like this:

Yes, you read that correctly! Greece killed its own banks. You see, many knew as far back as January (if not last year) that Greece would have a singificant problem floating its debt. As a safeguard, they had their banks purchase a large amount of their debt offerings which gave the perception of much stronger demand than what I believe was actually in the market. So, what happens when these relatively small banks gobble up all of this debt that is summarily downgraded 15 ways from Idaho.

Well, the answer is…. Insolvency! The gorging on quickly to be devalued debt was the absolutely last thing the Greek banks needed as they were suffering from a classic run on the bank due to deposits being pulled out at a record pace. So assuming the aforementioned drain on liquidity from a bank run (mitigated in part or in full by support from the ECB), imagine what happens when a very significant portion of your bond portfolio performs as follows (please note that these numbers were drawn before the bond market route of the 27th)…

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The same hypothetical leveraged positions expressed as a percentage gain or loss…

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Relevant subscription material for BoomBustBlog paying members:

    1. File IconGreece Public Finances Projections
    2. File IconBanks exposed to Central and Eastern Europe
  1. File IconGreek Banking Fundamental Tear Sheet

Online Spreadsheets (professional and institutional subscribers only)

Several months later I posted several followup pieces along the same vein:

To Cut or Not to Cut, The Irish Threaten To Play Rough With Those Clippers: Threats of Haircuts Rattle the ECB! Thursday, March 31st, 2011

I also made it very clear that haircuts and restructurings were on the table for Portugal.

The Anatomy of a Portugal Default: A Graphical Step by Step Guide to the Beginning of the Largest String of Sovereign Defaults in Recent History Tuesday, December 7th, 2010

Long Story, Short - The ECB Will Need Close to Infinite Funding To Pull The Whole EU Out Of This Whole Intact

It has been written about extensively:

  1. With Greek Debt Yielding 20%+ and Trading at Half Par Value, European Banks Are Trapped!
  2. It Should Be Obvious To Many That The Risk Of Defaulting Sovereign Bonds Can Spark A European Banking Crisis